active vs. passive investing: focus on small-cap equities
TRANSCRIPT
ACTIVE VS. PASSIVE INVESTING:FOCUS ON SMALL-CAP EQUITIES
QWAFAFEWJuly 18, 2002
Geeta M. Kapadia, Associate ConsultantStratford Advisory Group, Inc.
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OUTLINE
ÿ Active versus passive investment management: which is more successful for small-cap investing?
ÿ Which small-cap indices does Stratford use?
ÿ What are other methods of benchmarking small-cap managers?
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ACTIVE VS. PASSIVE: METHODOLOGY
ÿ Began with the Morningstar Principia Pro database
ÿ Eliminated funds that did not fall into the following asset classes:
ÿlarge-cap equityÿmid-cap equityÿsmall-cap equityÿinternational equityÿmarket duration fixed income
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ACTIVE VS. PASSIVE: METHODOLOGY
ÿ Further segregated the domestic equity asset classes into growth and value
ÿ Evaluated risk-adjusted performance over rolling five-year time periods spanning the ten years from 1991 to 2000
ÿ Limitations:ÿ survivorship bias (poor-performing funds tend to
leave the universe)ÿ database includes retail funds typically with higher
expenses than institutional funds
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ACTIVE VS. PASSIVE: RESULTS
ÿ The case for passive management: large-cap equities
-10%
0%
10%
20%
30%
40%
50%
-10% 0% 10% 20% 30% 40% 50%Risk (Standard Deviation)
Annualized Rate of Return
Five Years Ended December 31, 2000
30-day T-bill
S&P 500
Stratford’s Mean Universe Return
16.4%
5
0%
5%
10%
15%
20%
25%
30%
35%
40%
0% 5% 10% 15% 20% 25% 30% 35% 40%Risk (Standard Deviation)
Annualized Rate of Return
ACTIVE VS. PASSIVE: RESULTS
ÿ Not quite as convincing: international equities
Five Years Ended December 31, 1999
30-day T-bill
MSCIEAFE
Stratford’s Mean Universe Return
17.2%
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ACTIVE VS. PASSIVE: SMALL-CAP EQUITIES
ÿ Small-cap equity results were mixed
ÿ 1995, 1998, 2000 managers outperformed
ÿ 1996, 1997, 1999 inconclusive
ÿ Wide margin of out/underperformance
ÿ Small-cap value results were mixed
ÿUnderperformers lost more value than outperformers
added value
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ACTIVE VS. PASSIVE: SMALL-CAP EQUITIES
ÿ Small-cap growth results favored active management
ÿ Over periods measured, more managersoutperformed on a risk-adjusted basis than lagged
ÿ Outperformers did so by a wide margin
ÿ Active management during these periods wouldhave added more value than passive management
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ACTIVE VS. PASSIVE: QUALITATIVE FACTORSÿ Over 7,000 stocks in the small-cap universe
ÿ Both active and passive managers have high tracking error relative to the indices
ÿ Active management trading costs are high, as are active management fees
ÿ The typical small-cap stock has fewer analysts covering it than its large-cap counterpart
ÿ Analysts have easier access to small company management
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ACTIVE VS. PASSIVE: CONCLUSIONS OF THE STUDY
ÿ Active management will likely result in better returns for small-cap growth and international equities
ÿ Passive strategies will likely be more successful for large-cap, mid-cap, and fixed income markets
ÿ Final decision depends on an investor’s willingness to cope with each strategy’s tradeoffsÿ Do you like identifying outperformers?ÿ Are you a market timer?ÿ Do you have the time to commit to monitor active
managers?
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STRATFORD’S SMALL-CAP BENCHMARK USE
ÿ You guessed it - the Russell 2000 indices
ÿ Why?
ÿSimple data collectionÿSimple to understand and explainÿBroad universe of securities representedÿMost widely used by investment managers and the
public
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STRATFORD’S SMALL-CAP BENCHMARK USE
ÿ Why not use the Russell indices?
ÿ Peter’s comments on the rebalancing effect
ÿ Heavy technology weighting can unduly influence returns
ÿ Rebalancing only once a year can lead to market cap
and style creep
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STRATFORD’S SMALL-CAP PERFORMANCE MEASURES
ÿ Given the inherent problems with the small-cap indices, what other methods exist to measure small-cap manager performance?
ÿ Peer group performance over rolling periods
ÿ Peer group performance over calendar years
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STRATFORD’S SMALL-CAP PERFORMANCE MEASURES
Russell 2000 and S&P 600 Rankings within the Stratford Small-cap Equity Peer Group
0
25
50
75
1000201009998979695
Percentile Ranking
Russell 2000 S&P 600
Russell 2000
S&P 600
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STRATFORD’S SMALL-CAP PERFORMANCE MEASURES
Periods Ended Dec. 31Return Rank Return Rank Return Rank Return Rank
Russell 2000 2.5% 52 -3.0% 68 21.3% 31 -2.6% 41
S&P 600 6.5% 43 11.8% 40 12.4% 43 -1.3% 37
Small-cap Equity Peer Group Median 3.6% 50 7.4% 50 8.5% 50 -4.3% 50
2001 2000 1999 1998
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CONCLUSIONS
ÿ Qualitative and quantitative factors still favor active management over passive for small-cap equities
ÿ Despite flaws, the Russell 2000 indices continue to be the small-cap benchmarks of choice for managers and consultants
ÿ Peer group comparison is vital for a thorough evaluation of small-cap managers